4 Stocks For A Low Stress, Low Volatility Portfolio
When you hear the phrase “quality versus junk,” your mind may prepare to hear something insulting to or about somebody or something. Actually, that is an accepted label among academicians for a well-known “investment factor;” factor being defined as an objectively identifiable and testable set of characteristics shown to have a relationship to equity returns. It’s right there with size (labeled by academicians as large versus small), value (high book-to-market versus low book to market), etc. So I’m being completely serious when I say that over the past few months, junk has been hot and quality has been cold.
Stock Portfolios can aim at this too: Rocks spell out 'peace' in a small Zen garden. (AP Photo/Eric Gay)
Quality Versus Junk, the Factor
The nomenclature has to do with how academicians identify factors. When they test a factor, they compare hypothetical portfolios that have long positions in stocks that rate highly versus another portfolio that is made up of short positions in poorly ranked stocks. The difference (backed by lots of jargon such as R-square, t-tests, etc.) is the performance impact of the factor separate and apart from the impact of the market itself.
Based on research along those lines, it has become well accepted that ranking stocks on the basis of company quality can and does give investors valuable information.
Different researchers have different ways of defining quality but ultimately, everybody is aiming at the same thing and that is to rank stocks on the basis of factors that will likely result in more stable share return trends for highly ranked stocks and more volatility on the part of lower ranked stocks.
This may now be edging into more familiar territory: Beta is the famous indicator that measures how volatile stocks are relative to the market (1.00 being exactly as volatile, tallies above 1.25 meaning 25% more volatile, 0.90 signifying 10% less volatility, etc.).
Beta is OK (I should hope so, early research defining it led to a Nobel Prize), but in day-to-day investing, it’s so-so. It tells us how stocks did historically (it only measures historical returns and doesn’t consider any data at all about the company itself) so is prone to aberrations as weird things happen to companies at weird times that cause betas measured over one time period to be dramatically different from what they might be if different time periods were examined). And because it only uses historical returns, inferring future from beta alone can be a treacherous task.
However, share price performance doesn’t come from nowhere. So stocks are volatile or stable for reasons. Quality is a branch of analysis that examines, not the stock price, but the company characteristics that cause stocks to behave in particular ways. We look at things like margin, turnover, liquidity, debt and returns on investment. Higher measures under such quality factors tends to be associated with more stable trends in sales and earnings and stable trends in sales and earnings tend to result in more stable stock returns. Hence the link between quality and stability.
There’s Nothing Inherently Wrong with Low Quality (Junk)
So in the context of serious investing, all we say when we refer to a stock as junk is that its fundamentals are such that sales and earnings are likely to be more volatile. If you expect a good economy and a vigorous stock market, and you can handle the risk of being wrong if it turns out that way, then junk is what you should want. In a bull market, who wants a company whose earnings and stocks can rise 5% just because they could do almost likewise in a bad year. If you expect a good year, you can go for the hot company you think can grow 20%. It may drop 30% in a bad year, but if you’re a bull, that shouldn’t bother you as long as you have the wherewithal to refrain from crying or suing somebody if your expectations don’t pan out.
Junk Has Been Hot
The Trump election along with Republican dominance in Congress caused many to expect tax cuts, deregulation and all sorts of other wonderful things that would benefit businesses (hopefully including things that would benefit the ordinary folks that ultimately dictate the fate of businesses by buying or not buying but that wasn’t always the focus of the rhetoric). That led the investment community to stop worrying about stability and to chase shares of companies that seemed better postponed to benefit more extensively from good times. Ordinary people used phrases like industrials or financials. Academic types use the phrase junk over quality. It’s all the same.
The Portfolio Has Not
The stocks in the Portfolio123 Designer Low Volatility Select – S&P 500 portfolio (available for free on portfolio123.com) are not the ones you want to own if you want to try to outperform a hot market or bullish rally. This is the quality over junk group, the opposite end of the scale of what’s been popular lately and it is that way by design.
Figure 1 confirms this.
Figure 1
Figure 2 shows things for this quality-over-junk portfolio have been a bit better more recently, as investors have started to become a bit less giddy about life, or at least the stock ownership portion of life, on Planet Trump.
Figure 2
But I’m not going to cue the celebration. The near-term future of this portfolio is firmly tied to the investment community’s attitude toward risk. It is not a portfolio for all investors for all seasons. It is a portfolio for some investors for all seasons (those who want at least some low-volatility equity exposure at all times) or some investors during some seasons (i.e. for those who like to predict the market and who predict tough times ahead). Speaking for myself, I’m in the former group, which means these stocks (and/or others like them) represent permanent part of my equity exposure.
The Stocks
Figure 3 shows the current sector breakdown.
This portfolio does not openly make sector bets. But by seeking out stocks having characteristics likely to be associated with lower volatility, common sense tells us it’s going to wind up “overweight” in sectors that have more such businesses and companies. Also, large size is pursued because all else being equal, it tends to diminish volatility through decreased influence of fixed costs and better internal diversification.
Figure 3
You’re not necessarily going to get low valuation here. Many assume low P/Es etc. mean less risk. Actually, though, the opposite is true. Without getting mathematical here (I do it elsewhere, such as here), the formulation for a “correct” P/E, the same formula that tells us P/E can rise as growth rises, tells us that all else being equal, P/E must rise as risk falls. Risk protection is a benefit for which one must pay. That’s so in life (see, i.e., fire insurance, auto insurance, errors and omissions insurance, health insurance) and it’s so in the market, whether one pays premiums to own risk-reducing derivatives or higher P/Es to own shares of higher-quality companies (this strategy opts for the latter).
The Stocks
This low-turnover portfolio is refreshed every three months. The most recent trades are:
Sell
- Varian Medical Systems (VAR)
- United Parcel (UPS)
- Public Storage (PSA)
- O’Reilly Automotive (ORLY)
- McDonald’s (MCD)
- Foot Locker (FL)
- Church & Dwight (CHD)
Buy
Table 1 lists the current portfolio:
Table 1
Ticker | Company | Days Held * |
BCR | Bard (C.R.) | 826 |
BF.B | Brown-Forman | 371 |
CL | Colgate-Palmolive | 371 |
DPS | Dr Pepper Snapple Group | 189 |
EL | Estee Lauder Companies | 7 |
HAS | Hasbro | 7 |
HRB | Block (H&R) | 371 |
HRL | Hormel Foods | 1099 |
IFF | International Flavors & Fragrances | 7 |
ISRG | Intuitive Surgical | 917 |
JNJ | Johnson & Johnson | 553 |
KORS | Michael Kors Holdings | 7 |
LLY | Eli Lilly and Co. | 826 |
MO | Altria Group | 371 |
PM | Philip Morris International | 1099 |
ROST | Ross Stores | 735 |
* Days held is measured from its inception, on 1/2/99 as a simulation. The portfolio went live on 9/1/15, which is the period depicted above in Figure 1.
Disclosure: I’m long all stocks referenced in Table 1.